This week we sat down with Bruno de Radzitzky, our Head of Asset Management to take a look at “second round financing” and what it actually entails for investors and entrepreneurs.
Some of you might wonder why we decided to focus our attention this week on the second and not the first round; that’s why we’ll start by distinguishing the two phases:
1. The first round: like every seed or early stage company with little or no revenue, you’ll need to find funds to start your business. Whether it’s with the help of family, friends, business angels or VC funds, this phase is critical for entrepreneurs because it will enable them to make their dream a reality.
2. The second round: launching a business isn’t an exact science that’s why after a few months or sometimes years, start-ups always end up raising funds for a second round in order to develop their business even further, maintain their activity or sometimes save their company. This round is the trickiest one for entrepreneurs.
In order to understand the different scenarios which can occur during a second round, we first have to understand an important process that precedes each financing round: the company’s pre money valuation. This process determines the current worth of a company before each round by looking at the prospect of future earnings and market value of assets. This value also determines your share of the company and can sometimes drastically change between rounds, from better to worse or vice versa, and consequently affect people’s decision to invest, or to reinvest.
Based on these facts, here are three different second round scenarios:
The best case scenario: the company is booming and is in need of investment in order to pursue its growth. In most cases, and thanks to the rising valuation, the historical investors reinvest and new investors are often attracted and decide to join the adventure.
The basic scenario: the company has relatively well performed, despite its ups and downs, and is looking for funds to further its development. In most cases, the historical investors and the Venture Capital funds easily reinvest, even if the valuation hasn’t risen. However, if the fundraising round is quite high, the need for new investors is crucial and by bringing in new shareholders in the company, the risk of them challenging the valuation and the investor’s conditions arises.
The worst case scenario: the company hasn’t succeeded and the existing shareholders are feeling let down. In this scenario it is particularly difficult for entrepreneurs to motivate historical investors to reinvest especially because the valuation has dropped. If newcomers decide to invest and believe enough in the company, they will, in many cases, ask for some guarantees such as a liquidation preference (investors get paid first in case of an exit or solvent liquidation).
The question of dilution
As pre-existing investor who invested in the previous round, the law offers you a preferential right, i.e. the priority to reinvest in the following capital increase. If however you choose not to take advantage of this right, bringing in newcomers to the table, will automatically affect your shareholder percentage.
Suppose a company issues 100 shares to 100 individual shareholders. Each shareholder owns 1% of the company. If the company then plans a second round and issues 100 new shares to 100 more shareholders, each shareholder then owns 0.5% of the company.
As a cautious investor you will avoid putting most of your money in the first round. And in order to avoid the effects of dilution on your shares, the key would be to reinvest so that you own a larger share of the company.
To conclude, all start-ups necessarily have to go through a second round (sometimes third or even fourth) of financing, whether they are in good shape or not. As in most second rounds, the arrival of new investors causes the dilution of the existing shares and often changes in shareholder conditions can occur. That’s why at Spreds we do our best to be on top of things and always offer our investors the possibility to reinvest at the same conditions as the newcomers and, should there be substantial changes to the investment conditions, Spreds gives you a chance to vote on the final decision during a general asesmbly.